Series 7 candidates frequently ask me what the difference is between a so-called "covered call" and a "naked call." The difference is immense. In fact, the covered call is so much more conservative than the naked call that you can actually write covered calls in your IRA. Fortunately, the regulators don't let people risk unlimited loss by writing naked calls in their retirement account.
So, what's the difference between the two positions? First, remember that whenever you write a call, you take on the obligation to sell a stock for a set price, no matter what. If you write an XYZ Mar 50 call, you are obligated to sell somebody 100 shares of XYZ for $50 per-share, regardless of what you have to do to get the shares. If you don't have the shares when you write the call, you are totally exposed to the risk that the stock price will rise, since the rising market price is what you have to pay to get the stock that you then have to sell for $50. What if the stock pulls a Google on you and rises to $450 a share?
You will be very, very sad. Imagine paying $45,000 for 100 shares of stock that you have to sell for $5,000. Per contract. Oh, wait—what’s that? Oh, you collected $200 in order to lose the 40 grand; I stand corrected. So, since the stock price can rise to an unlimited value, and since that unlimited and unknown value represents your purchase price on the stock, you are standing out there naked and exposed to the harsh elements, all in exchange for a premium. If you wrote that XYZ Mar 50 call "at 2," you took in $200 per contract for your maximum gain. Your maximum loss? Unlimited. Think about that risk-reward ratio. I can make $200 per contract or lose my house—gee, where do I sign up? I wanna write naked calls.
On the other hand, if you already owned 100 shares of XYZ, you would be covered. If the stock rises above $50 per share, you just deliver the shares you already own and walk away. If you had bought those shares for, say, $30, you would actually make a nice profit when the stock is called away from you at $50 a share, plus the little premium, as well. Now, please don't make the mistake so many students do in assuming that if you write an XYZ Mar 50 call, you will sell the stock at $50. No! You will sell the stock at $50 only if it rises above $50 per share. If the stock drops, the call expires. That's the idea when you write a naked call--take the premium and watch the other guy lose the bet when the stock drops faster than the Chicago Cubs in late August. But, when you write a covered call, you have to remember that you own that stock which is now dropping. And that's a bad thing. If you bought XYZ common stock for $50 and wrote an at-the-money XYZ Mar 50 call @2, you took in $200. Covered call enthusiasts would point out that earning $2 immediately on a $50 stock is a 4% return. If the call expires in 2 months, you could multiply that 4% by 6 and call it a "24% annualized rate of return." I prefer to call it "$200.” And, in this case, $200 is your maximum gain. If the stock goes up, it's called away, end of story. You make nothing on the stock--the premium is all you get. Your risk would be on the downside in this covered call position. If the stock drops, it just keeps dropping. You don't "get to" sell your stock @50; you were obligated to do that, and only if the stock had gone up, above $50. On the way down, you're in the same boat as anyone who owns the stock all by itself. If the stock drops to zero, I doubt you'd feel special having lost only $4,800 while you woulda' lost $5,000. Now we can see why Series 7 questions will talk in terms of "increasing overall return" and "limited protection" in reference to a covered call. The premium does increase your overall return/yield. In other words, while the stock is just sitting there in your account, why not use it to generate some premium income? But, remember that the premium income is all you get. If you collect $2 a share, then $2 a share is the full extent of your "protection." If you buy 100 shares of XYZ for $5,000, you could lose $5,000; if you wrote a covered call for $200, you could then lose $5,000 minus that premium ($4,800). So, the covered call is not about protection so much. It provides the premium. That means you get some extra income, minimal downside protection, and if the stock should ever rally, it is called away, capping your upside potential.